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Beware Bitcoin

Guest contribution in the Frankfurter Allgemeine Sonntagszeitung newspaper published on 04.02.2018

Extreme price jumps, the launch of Bitcoin futures, and new funding options such as initial coin offerings add fuel to the fantasies surrounding virtual currencies. But the truth behind Bitcoin and its ilk often fades into the background. Anyone wishing to judge should take note of a few economic and environmental concerns.

Bitcoin is made up of cryptographically encrypted digital units that can be used for payments. Units are issued anonymously on the basis of blockchain technology, circumventing banks and central banks, and can be used worldwide. Anyone can “mine” Bitcoin using a computer’s processor to validate Bitcoin transactions in line with the underlying algorithm and thus create new “blocks”, for which they will be awarded bitcoins. That’s the theory. In practice, however, the disadvantages of Bitcoin are clear.

Bitcoin is not a currency. Bitcoin is often referred to as a “virtual currency” or “cryptocurrency”. This conveys the misconception that Bitcoin is on a par with currencies like the euro, the US dollar and the yen. Yet Bitcoin is not issued by a central bank, nor is it recognised as legal tender by any state.

Using Bitcoin is costly. The basic idea behind Bitcoin is that it should be free of transaction fees worldwide. Fees are only envisioned for transactions that need to be settled especially quickly, and for a long while they played just a minor role. However, mining new transaction blocks has since become so onerous that transactions for which the user doesn’t pay a fee to the miner are rarely verified and booked. The processing fees have been higher than €30 at times. One of the reasons they have risen is because of the higher “production costs” in the Bitcoin network, as miners are awarded bitcoins for their work and thus profit from Bitcoin price rises.

When a growing number of miners generate increasing IT processing power in the Bitcoin system, the algorithm reacts by automatically increasing the power needed to mine new transaction blocks. The required processing power has now risen to such a level that mining has evolved into a highly specialised industry. Computers optimised for mining are able to process ever more complex operations. Companies run mining farms, where thousands of these specialised computers mine new transaction blocks day and night. These farms need so much power that they are run in Inner Mongolia in China, for example, where electricity costs are especially low.

Using Bitcoin is extremely energy-intensive. The amount of power needed to mine Bitcoin can’t be calculated precisely. The website Digiconomist estimates that the entire Bitcoin network currently consumes just over 46 terawatt hours of energy every year. This is almost as much as the annual energy consumption of Portugal, with its population of roughly ten million. Simply settling a transaction in the Bitcoin network consumes around 427 kilowatt hours. This amount of energy is enough to supply an average German four-person household with electricity for more than a month. By way of comparison, just settling a standard SEPA transfer (without the payer initiating the transfer or checking their account balance on a PC or smartphone) takes less than one watt hour. On the whole, the Bundesbank estimates that settling a Bitcoin transaction uses roughly 460,000 times as much electricity as a normal transfer.

Holding Bitcoin is risky and highly speculative. The heavy fluctuations in Bitcoin’s value over the past few weeks just go to show that Bitcoin is a high-risk speculative plaything. It’s also possible for Bitcoin holdings to be completely wiped out. What is more, events like the insolvencies of Bitcoin exchanges such as Mt. Gox and Bitstamp and hacker attacks have patently shown that Bitcoin users face an incalculable risk of losing their stored balances on trading platforms. Purely as an investment form, Bitcoin is classed as highly speculative since it has no inherent value, unlike precious metals, say.

Bitcoin plays no role in economic life. Bitcoin’s rapid price development should not detract from the fact that Bitcoin still plays an insignificant role as a means of payment. Last year, around 350,000 Bitcoin transactions were conducted each day around the world, but that’s compared to 70 million transfers, direct debits and card payments per business day in Germany alone (in 2016). Another reason why Bitcoin is not becoming an established means of payment is because Bitcoin payments are mostly concluded by exchanging bitcoins for an official currency, and this exposes the recipient of the payment to a not inconsiderable amount of exchange rate risk. Risk costs also have to be considered. For example, there are no generally binding legal rules for the settlement of Bitcoin payments. While conventional payments are covered by legal rules stipulating what claims the customer can make on the payment service provider if something goes wrong with a payment transfer, a Bitcoin transaction is always final and irreversible.

Bitcoin is one of around 1,400 virtual currencies currently in existence. But Bitcoin is the biggest and most prominent of the lot, and its anonymous issuance feature also makes it one of the most radical in design. From an economic and environmental perspective, Bitcoin has reached its limits; the benefits of Bitcoin as a means of transaction are vastly disproportionate to the high transaction fees and the extreme energy consumption.

Because of the risks that Bitcoin entails plus the risks posed by new ways of raising capital, such as initial coin offerings, which the Federal Financial Supervisory Authority (BaFin) had already pointed to last year, the international debate about potential regulation has intensified recently. The chief issues are money laundering and measures to combat terrorist financing for exchanges and providers of “wallets” used to store virtual currencies, in addition to investor protection. As part of the ongoing revision of the EU’s Anti-Money Laundering Directive, these obligations should also be extended to Bitcoin exchanges, amongst other things.

But the criticisms of Bitcoin and other virtual currencies should not take away from the fact that blockchain technology promises great potential for innovation. It paves the way for distributed databases, for which each participant has read and write permissions, that can be programmed to initiate transactions (such as payments) autonomously. On the basis of this technology, processes involving many participants can be completely redesigned. It could be used, for example, to deliver electricity in decentralised networks, to settle delivery-versus-payment transactions in foreign trade, to set up photo databases, and equally for any number of back-office processes.

The Bundesbank is conducting a very detailed analysis of the potential applications of blockchain technology in the various areas of the financial sector. A joint project with Deutsche Börse is testing the application and performance of blockchain technology in the settlement of securities transactions between banks. Right now, we do not see payment transactions as the most suitable area in which to apply the new technology, as the main focus here is the settlement of millions of bilateral transactions. Conventional payment systems, thanks to their lower costs and, not least, the launch of instant payments in November 2017, will therefore remain the superior solution for the foreseeable future. With instant payments, payments in euro can be made within seconds, for instance using a mobile phone. More and more credit institutions in Europe are offering these payments. The huge interest in virtual currencies may dissipate if existing payment systems become even more efficient and even faster than they already are.